How brokerages make money - or why payment for deal flow is OK

I just read Patrick’s blog post about this and would totally recommend:

https://www.kalzumeus.com/2019/6/26/how-brokerages-make-money/

What does the Freetrade community think about payment for deal flow? How much of the content does not apply to the UK because of pricing/size/economics? I’m a n00b in this area but curious to learn more from the people here. Any opinions?

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Payment for order flow (POF) is banned in the UK as of 2012 by regulators citing conflict of interest:

POF is basically where a broker, lets say Hargreaves Lansdown, takes a client’s orders, and sells them to a market maker , lets say the london stock exchange (technically the LSE isnt a market maker, they just work with them, but lets keep things simple) for a fee. LSE/market makers then pocket the difference between the buying and selling price ( the “spread”) on that client’s order. Very shady business.

Trouble is, brokers are supposed to execute orders based on what gives the fairest price, but POF incentivises them to just sell their orders to whichever market maker pays them the most, leaving the everyday investor paying an unfair price. POF is still legal in the US for now, and is how Robinhood make most of their money, infamously so. Whats also messed up is not everyone. It’s all quite interesting stuff, POF, and poses the broader question of how lucrative, or even viable, a zero commision broker could be in the UK, or just anywhere markets are or will be tightly regulated.

If Freetrade (FT) ever reject your order, it’s probably because they’re trying to get you a fair price and couldn’t. whereas the less ethical brokers (literally everybody else) probably would have just went “f*** them lol”. There are still a few challenges before we have fairer markets, but as freetrade grows, and stock exchanges innovate(still waiting for a decentralised stock exchange tbh), I expect we’ll have even fairer prices. Now that I think of it, visible bid/offer spreads would be a great app feature in line with FT’s transparency… vote here

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Interestingly, it is clearer to me now why Robinhood has been struggling to establish in the UK - their business model would simply be illegal :sweat_smile:

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Matt Levine has a counter-argument that payment for order flow is good (as practiced by Robinhood anyway):

“there is a controversy about Robinhood’s use of payment for orderflow. I find this controversy baffling and annoying because it is absolutely crystal clear that this is good for you: Robinhood charges high-frequency traders for the privilege of selling you stock at better than the market price, and then uses the fees it collects from them to let you trade for free. If you went to a regular broker and demanded that your order be routed to the stock exchange with no payment for order flow, (1) you would pay a commission and (2) you would get a worse price for the stock.”

Which obviously has no relevance in jurisdictions where POF is illegal!

That’s essentially the opinion of Patrick in that blog post as well. The fact that the broker makes money from it doesn’t mean it’s not better for consumers.

Even though Robinhood makes the majority of their revenue from this now - I wonder if that’s their long-term plan. People accuse them of it, but it might just be a stopgap measure to get more revenue now while they grow, before they reach a scale for a freemium model to make more sense.

@sparklesandsweat Any link to evidence that it’s illegal in the UK?

I guess it’s Mifid2, and possibly earlier:

“We are writing to reiterate that firms who continue to charge PFOF will breach the new standards implemented in MiFID II, remind firms that they must take action now to ensure compliance and to warn against any attempted models that seek to avoid these rules” https://www.fca.org.uk/publication/correspondence/dear-ceo-letter-payment-for-order-flow.pdf

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Slightly on a tangent, but seems like commission free brokers are popping up left right and centre at the moment.

Evarvest partially successfully crowdfunded on Seedrs recently, and now StockTwits that they will soon be launching a Trade App for commission free brokerage, albeit in the US only. Seems like the market is definitely growing globally.

Largely a problem related to low-liquidity stocks, which FreeTrade is avoiding for now.

If you do go into this area, clients are going to demand a Level 2 order book, as low-liq (and therefore material spread say >3%) trading is always done with an eye on the book.

Interestingly, on the FreeTrade EOD settlement model, this job would fall to FreeTrade, not the customer.

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